Protege of star manager Dan Fuss outperforms her former boss but her track record is short

Kathleen Gaffney spent 15 years as understudy to star bond manager Dan Fuss at Loomis Sayles & Co. A year and a half after starting her own fund, she's beating her old boss and the rest of the bond world.

Ms. Gaffney's Eaton Vance Bond Fund, which opened three months after she left Loomis Sayles in October 2012, returned 19% over the past year, better than 99% of peers, according to data from Morningstar Inc. The performance has attracted investor cash, boosting the fund to $1 billion from $124 million at the end of 2013.

“I think the world of Kathleen,” said Mr. Fuss, whose comparable fund returned 16% in the past year. “She has the ability to cut to the heart of things.”

Ms. Gaffney, 52, left Loomis Sayles at a difficult time for bond funds as the Federal Reserve's unprecedented stimulus pushed down yields and confounded investors, including Bill Gross at Pacific Investment Management Co. Since then, she's prospered with a style of investing long associated with Mr. Fuss, who's built among the best track records in the industry by buying bargain assets from stocks to high-yield bonds and avoiding Treasuries.

“People said it was a crazy time to start a bond fund because interest rates were so low,” Ms. Gaffney said in an interview at her office at Eaton Vance Corp., about a 10-minute walk through downtown Boston from Loomis Sayles.

BEATING PEERS

Ms. Gaffney went through multiple credit cycles at Loomis Sayles after joining in 1984, soon after graduating from the University of Massachusetts in Amherst. Her only other post-college job was as a cashier at the local A&P supermarket.

Ms. Gaffney moved up through the ranks at Loomis Sayles, working on equities, convertible bonds and fixed income. In 1997, she was made co-manager on Mr. Fuss' flagship Loomis Sayles Bond Fund. (LSBDX) Over time she played a more visible role on the fund, speaking on conference calls to advisers and at industry forums.

What she could not do was take over the fund, because Mr. Fuss, who turned 80 last year, made it clear he had no intention of retiring.

Well past the age when most American's retire, Mr. Fuss has continued to outperform. His $18.7 billion Natixis Loomis Sayles Strategic Income Fund (NEFZX), which has a similar asset mix to Ms. Gaffney's offering, returned 16% over the past 12 months, ahead of 98% of rivals.

His $24 billion Loomis Sayles Bond Fund has advanced at an annual rate of 13% over the past five years, beating 98% of peers over that period. The fund plunged 22% in 2008, lagging behind 97% of competitors, before rebounding to near the top of the ranks the following year.

'OWN SHOW'

“She wanted to run her own show,” said Hal Rubin, who hired Ms. Gaffney at Loomis Sayles and later founded Salem Capital Management in Woburn, Mass.

When she is not working, Ms. Gaffney spends time with her two Labrador retrievers as she and her photographer husband are now empty-nesters. Ms. Gaffney has two daughters, one of whom is in college and the other attending graduate school in clinical psychology. Ms. Gaffney recently finished a two-year term as president of her local Unitarian Universalist church.

Eric Jacobson, co-head of fixed income research at Morningstar, said it is a little early to judge Ms. Gaffney's performance.

“You will need to see how she handles a troubled period.”

After years of holding benchmark interest rates near zero and bolstering the market through asset purchases, the Federal Reserve last year said it would start to unwind its unprecedented stimulus. The prospect of rising interest rates prompted investors to pull money out of bond funds last year, including record redemptions from Mr. Gross's Pimco Total Return.

Ms. Gaffney's style of security selection may be attractive in a period when returns on mainstream bond funds were limited by low yields. Nontraditional bond funds, which are designed to make money even if rates rise, have proven popular with investors, gathering $53.2 billion in deposits over the past year, including $19 billion in the first five months of 2014, according to Morningstar data.

Eaton Vance Bond Fund (EVBAX), which can put as much as 20% of its money in stocks, had 16% of its assets in equities as of March 31, according to the firm's website, and another 10% in convertible bonds, which can be swapped for stocks under certain circumstances.

Ms. Gaffney sees an improving U.S. economy, which makes this a good time to take credit risk. The problem: both investment-grade and high-yield bonds are “extremely overvalued,” in her view, and vulnerable to rising rates. She said the yield on the 10-year Treasury bond, currently about 2.6%, could touch 4% by the end of the year.

“The best way to take advantage of an improving economy is to have exposure to equity and equity-like structure,” said Ms. Gaffney.

Ms. Gaffney owns shares in Caterpillar (CAT) Inc., the biggest maker of construction and mining equipment. The stock, up 19% this year, is reasonably valued, will benefit from an economic rebound and has a dividend yield of 2.6%, said Ms. Gaffney.

By contrast, Caterpillar's 3.75% bond due in 2023 yields 3.2%, according to data compiled by Bloomberg. That yield could be hurt if interest rates go up, said Ms. Gaffney. Caterpillar in May issued 50-year bonds, which may not be a good investment, Ms. Gaffney said.

“It's an excellent deal for the company, but not necessarily for bondholders,” she said.

'HOME RUN'

Ms. Gaffney bought a convertible bond from chip maker Micron Technology Inc. when her fund started in January 2013, and sold it at the end of the year. Micron is benefiting from consolidation in the semiconductor business, which has led to more stable prices for its products.

Micron's 1.875% convertible bond due in 2031 more than doubled last year, according to data compiled by Bloomberg.

“It was a home run,” said Ms. Gaffney.

While Ms. Gaffney considers many corporate bonds overvalued, she will buy them if she is getting paid for the risk. She invested in bonds from computer maker Dell Inc. in January 2013 after founder Michael Dell began talks to take the company private in a leveraged buyout. The deal was completed in October.

“You can often find value where there is uncertainty,” said Ms. Gaffney.

Dell's 5.4% bond that matures in 2040, which was downgraded by Standard & Poor's to junk status in September, lost value after Ms. Gaffney bought it, falling from about 92 cents on the dollar to less than 70 cents in November. The bond has since recovered to about 87 cents.

Ms. Gaffney continued buying Dell as prices fell.

“We view it as a strong turnaround candidate that will return to investment grade,” she wrote in an e-mail.

As high-yield bond prices have climbed to 106 cents on the dollar from 103 cents at the end of 2013, Ms. Gaffney has increased holdings of cash. Cash in the fund has built to almost 15% from 7 percent as of March 31, because there are fewer attractive things to buy, said Ms. Gaffney.

Ms. Gaffney's visibility at Loomis Sayles has made it easier for her to raise money. Jeffrey Harrell, an investor in Loomis Sayles Bond Fund, was impressed by Ms. Gaffney at Loomis Sayles and decided to put money in her Eaton Vance offering.

“In our opinion it was a no-brainer to get in on the ground floor of her new fund,” Mr. Harrell, director of portfolio management at McGill Advisors in Charlotte, N.C., said. The firm oversees more than $1 billion and still holds shares of Mr. Fuss' fund.

While he has confidence in Ms. Gaffney's ability, Mr. Harrell said her fund comes with risks.

“If stocks get crushed, she will do poorly,” he said.

Ms. Gaffney said starting afresh after so many years at Loomis Sayles was daunting.

“But I like uncertainty,” she said. “I have found you can profit from it if you do your homework.”

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